Saturday, August 23, 2014
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A Time to Dare

NEW YORK – The upcoming G-20 meeting is a make-or-break event. Unless it introduces practical measures to support the countries at the periphery of the global financial system, global markets will suffer another round of decline, just as they did after United States Treasury Secretary Timothy Geithner’s failure in February to produce practical measures to recapitalize America’s banking system.

The current financial crisis is different from all the others we have experienced since World War II. On previous occasions, whenever the financial system came to the brink of a breakdown, the authorities got their act together and pulled it back from the brink. This time the system actually broke down in the aftermath of Lehman Brothers’ collapse last September, and it had to be put on artificial life support. Among other measures, both Europe and the US have effectively guaranteed that no other important financial institution will be allowed to fail.

This step was necessary, but it produced unintended adverse consequences: many other countries, from Eastern Europe to Latin America, Africa, and Southeast Asia, could not offer similarly convincing guarantees. Abetted by the determination of national financial authorities at the center of the world economy to protect their own institutions, capital fled from the periphery. Currencies fell, interest rates rose, and credit default swaps soared. When the history of this crisis is written, it will be recorded that – in contrast to the Great Depression – protectionism first prevailed in finance rather than trade.

The International Financial Institutions (IFIs) are now faced with a novel task: to protect the periphery countries from a storm that emanated from the center. They are used to dealing with governments; now they must learn to deal with the collapse of the private sector. If they fail to do so, the periphery economies will suffer even more than those at the center.

Countries on the periphery tend to be poorer and more dependent on commodities than the more developed world, and they must repay more than $1.4 trillion in bank loans in 2009 alone.  These loans cannot be rolled over without international assistance.

British Prime Minister Gordon Brown recognized the problem and placed it on the G-20’s agenda. But, in the course of preparations, profound attitudinal differences have surfaced, particularly between the US and Germany. 

The US has recognized that only using the credit of the state to the fullest extent possible can reverse the collapse of credit in the private sector. Germany, traumatized by the memory of hyperinflation in the 1920’s and the consequent rise of Hitler in the 1930’s, is reluctant to sow the seeds of future inflation by incurring too much debt. Both positions are firmly held and can be buttressed by arguments that are valid from the point of view of the country concerned. But the controversy threatens to disrupt the April 2 meeting.

It should be possible for each side to respect the other’s position without abandoning its own and to find common ground. Instead of setting a universal target of 2% of GDP for stimulus packages, it is enough to agree that the periphery countries need international assistance to protect their financial systems and engage in countercyclical policies. That is in the common interest. If the periphery economies are allowed to collapse, developed countries will also be hurt.

As things stand now, the G-20 meeting will produce some concrete results: the resources of the International Monetary Fund are likely to be effectively doubled, mainly by using the mechanism of the New Arrangement to Borrow (NAB), which can be activated without resolving the vexing question of reapportioning voting rights in the IFIs.

This will be sufficient to enable the IMF to come to the aid of specific countries in trouble, but it will not provide a systemic solution without conditionality. Such a solution is readily available in the form of Special Drawing Rights (SDR). The mechanism exists and has already been used on a small scale.

SDRs are highly complicated and difficult to grasp, but they boil down to the international creation of money. Countries that are in a position to create their own money do not need them, but the periphery countries do. Rich countries should therefore lend their allocations to the countries in need.

This would not create a budget deficit for rich countries. Recipient countries would have to pay the IMF a very low interest rate: the composite average treasury bill rate of all convertible currencies. They would have free use of their own allocations, but the IFIs would supervise how the borrowed allocations are used to ensure that the borrowed funds are well spent. It is difficult to think of a scheme where the cost/benefit ratio is so favorable.

In addition to the one-time increase in the IMF’s resources, there ought to be substantial annual SDR issues, say, $250 billion, as long as the global recession lasts. To make the scheme counter-cyclical, the SDR issues could be callable in tranches when the global economy overheats. It is too late to agree on issuing SDRs at the upcoming G-20 meeting, but if it were proposed by President Barack Obama and endorsed in principle by the majority of participants, it would be sufficient to give heart to the markets and make the meeting a resounding success.

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